Thirty years ago, the economics profession was dominated by naive Keynesians. The author of the standard textbook at the time, used by the majority of A-level students and first-year undergraduates, argued that the misery of the 1930s depression would have been much reduced had those in authority known even as much economics as was contained in his book. This so-called economics involved the belief that an increase in saving and taxation or a reduction in government spending necessarily reduced national income. The author stated that there was no space to discuss alternative “extreme” views in his 810 page book. On 23rd March 1981, 364 economists took their cue from the textbooks and wrote to The Times strongly criticising fiscal retrenchment and arguing that: “present policies will deepen the recession.”

Naive Keynesianism should have been buried that year. Within a few weeks, economic data was released that showed that the letter was written in the very month that domestic demand recovered. Most economists have moved on but there are remaining habitats of naive Keynesianism in the Financial Times, the BBC and the upper-reaches of the Labour Party.

So, should we, as Ed Balls and others suggest, increase government borrowing to get economic activity back on the move – in other words, follow “Plan B”? The argument these people use is that, if we do not do so, we will be repeating the mistakes of the 1930s. A paper published today by the Institute of Economic Affairs, written by Kent Matthews shows both the thesis and the analogy to be flawed.

The path of national income in the first three years of the Great Depression was similar to that in the UK since 2008. If we were following the 1930s path today, we would just be ready to embark on a period of healthy growth, rapid house building, and so on. Within five years the economy would not only be much bigger than today, it would have caught up with its trend level as if the financial crash had never occurred. All this happened without the “aid” of fiscal policy – borrowing was much, much lower than today’s levels. The modelling that Matthews has analysed suggests that an expansionary fiscal policy would have had very few, if any, benefits in the 1930s. Indeed, we are doing worse today, with much higher borrowing.

Interestingly, the US economy experienced the longest Great Depression of any leading nation. FDR’s expansion of government borrowing – admittedly erratic – did not work and his tax and regulatory policy strangled the economy. The policy environment in the UK in the 1930s certainly compared favourably with that in the US then and,arguably, with that in the UK today. And better out turns were achieved with government borrowing around one per cent of national income.

We do, however, face a policy dilemma. In the early 1930s, we ran a loose monetary policy. This was appropriate in the circumstances, Matthews suggests, because output was way below capacity. But, it is possible that the crash of 2008 led to a permanent shock to economic capacity. If that is the case, the economy might, in fact, not be below trend. The expansion of welfare and increases in taxation and regulation might have contributed to this phenomenon too. In this scenario we should tighten monetary policy to avoid inflation. There is an analogy herewith the 1920s when there was a permanent loss of productive capacity for various reasons, some of which were related to the First World War.

So, the only realistic policy choice we face is between “Plan A” – loose monetary policy and tight fiscal policy – and what might be called “Plan C”. Plan C would involve both tight monetary policy and tight fiscal policy to avoid inflation continuing.

This is bad news for Balls when it comes to the debate surrounding fiscal policy – but there is worse. Looser fiscal policy, it seems, would have been ineffective in the 1930s, but it would be even more ineffective today. Research suggests that open economies on floating exchange rates that are already heavily indebted do not respond positively to increased government borrowing. There are good reasons for this. Consumers lose confidence and, if the government raises borrowing, either interest rates or the exchange rate will tend to rise and choke off domestic activity.

This is not to say that there is nothing the government can do. Regardless of whether we are in a 1920s or a 1930s scenario, radical supply-side reform and deregulation can both raise the maximum capacity of the economy and increase the speed at which we return to that maximum capacity. Instead of just looking at the Treasury we should demand action from every single department of state to reduce the role of government in economic life. Policies to achieve that would be the perfect complement to fiscal retrenchment.